The U.S. Trade Deficit is NOT a Vice

The public is consistently fed doomsday scenarios from sources that absolutely should not be ill-informed, including the International Monetary Fund, the Federal Reserve and the Treasury.

These guys should be the most informed bunch of all. But many are dead wrong when it comes to the U.S. current account deficit and its doomful impact on the U.S. dollar.

Don’t Be Misled — The U.S. Trade Deficit is NOT a Vice

We learned on Thursday that the U.S. trade deficit widened to a 16-month high in the month of July.

Yes, I know the lofty price of crude oil had a lot to do with the widening deficit. And the steep plunge in oil prices is set to narrow this deficit in coming months. That’s all well and good. But even if the deficit remained as is, would it really be all that bad?

July’s trade deficit hit a 16-month high.

Here’s the myth:

The U.S. trade deficits grow by inordinate amounts each year. The United States simply cannot sustain such debts to foreign nations. What happens when foreign nations refuse to fund our cravings to spend, spend, spend? Ultimately we must pay back these borrowings, and when the time comes we won’t be able to do that. U.S. Economic Armageddon is looming.

Now let me explain three reasons why that myth is wrong …

Myth Busting Reason #1:It’s All Relative …

There’s no doubt that the U.S. current account deficit is an astronomical number. But due to the growth trends in money supply over many years, figures in the billions and trillions of dollars are now commonplace … and will only grow larger. But like so many other things, it’s a relative game. And that’s where this trade deficit theory goes wrong …

The U.S. current account deficit for all of 2007 relative to, say, U.S. assets isn’t so bad. In fact, the annual trade deficit last year only made up a small, 1.2% of U.S. net worth. That’s hardly approaching worrisome levels, much less the catastrophic, dollar-is-dead-where-it-stands levels that so many doomsayers preach.

And even when you consider that foreign debt sits at around $2 trillion and is growing at a rate of 5% per year, the U.S. is in perfectly fine shape. That’s because the U.S. net worth of more than $50 trillion is growing by roughly $3 trillion a year.

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Forget for a moment that U.S. imports consistently outpace U.S. exports. The deficit only measure sales, when in fact profits go overlooked.

Take the example of a computer. While it may cost $500 to have it assembled and shipped from overseas, it might sell for $800 in the U.S. We realize a trade deficit of $500, yes. But we also realize a sizeable profit margin on the computer’s sale.

Myth Busting Reason #3:The U.S. is in the Banking Business …

In just three months, the U.S. earned $100 BILLION from its banking business.

The U.S. is currently borrowing $731 billion per year from foreign investors, just as a bank would. And at the same time the U.S. is earning a return on its foreign assets and foreign direct investments. What it earns on those assets more than makes up for what it borrows.

For instance, income on U.S. assets owned by foreigners grew by $197 billion in the three months ending in March 2008. At the same time, income on U.S.-owned assets and direct investments abroad jumped by $295 billion. That’s a net positive of roughly $100 billion of income for the U.S. in the first quarter alone.

If this were unsustainable, foreign debt would make up a far larger proportion of U.S. net worth and would be growing much faster than the current 5% per year. Also, the U.S. would be losing out on its investments or at least realizing smaller yields on its foreign investments relative to what foreigners earned on investments in the U.S.

Dollar Bears are Having a Change of Heart

You may be wondering, though, if the current account is not responsible for structural dollar weakness why then has the dollar cratered for the last seven and a half years?

Here are two reasons:

It was time for prices to adjust. Currencies go through cycles, just as economies do. After a sizeable run from 1995 through 2001, the U.S. dollar was sitting high, and needed to come back down to earth. During this time global dynamics, speculation and U.S.-dollar sentiment all shifted to shake up the investing environment. Various negative-U.S. revelations only added to the selling momentum along the way.

Diminishing confidence in U.S. capital markets and the U.S. financial system. This gained traction at the beginning of the dollar’s bear market that began in early 2002 and then again in 2007. Not surprisingly those periods were marked by the Nasdaq bubble and the housing/subprime bubble. Perhaps legitimate cause for concern at the time. But U.S. capital markets remain among the deepest and most efficient in the world.

Ironically though, we may have reached a point where each of these dollar drivers remains in play … only this time in the other direction.

The dollar has had a long fall, and it’s due for some strengthening. No longer is the U.S. the only major economy that’s suffering. To that point, a softening global economy and a lingering credit crunch are leading to a major shift in money flow. Dollars are coming back into U.S. capital markets.

And that’s very supportive of the U.S. dollar.

Best wishes,

Jack

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Money and Markets (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Tony Sagami, Nilus Mattive, Sean Brodrick, Larry Edelson, Michael Larson and Jack Crooks. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive. Regular contributors and staff include Kristen Adams, Andrea Baumwald, John Burke, Amber Dakar, Dinesh Kalera, Christina Kern, Red Morgan, Maryellen Murphy, Jennifer Newman-Amos, Adam Shafer, Julie Trudeau and Leslie Underwood.

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